TXU Teeters as Firms Reap $528 Million Fees: Corporate Finance

PublishedOctober 23, 2012

Oct 21, 2012

By Richard Bravo and Mark Chediak
Bloomberg News

KKR & Co. (KKR), TPG Capital and Goldman Sachs Capital Partners (GS), which took the former TXU Corp. private five years ago in the largest leveraged buyout in history, have paid themselves $528.3 million in fees, even as the electricity provider teeters toward a near-term bankruptcy or restructuring.
The payments consist of a $300 million charge for advising on the buyout, annual management fees totaling $171 million and as much as $57.3 million for consulting on debt deals, the Dallas-based company now called Energy Future Holdings Corp. said in regulatory filings. The private-equity firms’ fees are as much as 25 times greater than average, based on data from law firm Dechert LLP and researcher Preqin Ltd.

Energy Future’s long-term debt has soared to $42 billion since the buyout and the company is poised for its seventh straight quarterly loss as it struggles with natural gas prices 73 percent below their 2008 peak. Moody’s Investors Service says the company may need to restructure next year and derivatives traders are pricing in a 95 percent chance of default within five years for its deregulated unit.

"This is a utility and its product is electricity that it sells to the public, but it really is a debt house," said Tom Sanzillo, finance director for the Institute for Energy Economics & Financial Analysis, a research group, and former deputy comptroller of New York who oversaw the state’s $156 billion pension fund. "There are fees to be made in all that debt management."

Technically Insolvent

The company, which traces its roots in North Texas to 1882, expects to post a third-quarter net loss of $407 million on operating revenue of $1.8 billion, according to an Oct. 18 filing. Energy Future plans to release its full earnings report on Oct. 30. Total liabilities were $52.2 billion as of June 30, compared with total assets of $44.1 billion, according to data compiled by Bloomberg, indicating the company is technically insolvent.

The fees from Energy Future may allow KKR, TPG and Goldman Sachs to extract cash without infringing on the Delaware Limited Liability Company Act, which limits distributions from a firm if all its liabilities exceed the fair value of its assets, according to Chapter 18 of the law.

The company’s Energy Future Intermediate Holdings Co. LLC, Texas Competitive Electric Holdings Co. and Oncor Electric Delivery Holdings Co. LLC units were incorporated in Delaware and are subject to the laws of that jurisdiction, Allan Koenig, a spokesman at Energy Future, confirmed in an e-mail.

Default Swaps

Kristi Huller, a KKR spokeswoman, Owen Blicksilver, a spokesman for TPG with Owen Blicksilver Public Relations Inc., and Andrea Raphael of Goldman Sachs declined to comment.

Five-year credit default swaps tied to Texas Competitive have soared to 79 percentage points upfront as of Oct. 19, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.

That’s in addition to 5 percent a year, meaning it would cost $7.9 million initially and $500,000 annually to protect $10 million of its debt for five years. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

Texas Competitive’s $1.8 billion of 10.25 percent bonds due November 2015 traded at 26 cents on the dollar last week from a high of 88.5 cents in January 2010, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

"Pay Our Debts’

"We continue to pay our debts as they become due and have always been and remain in compliance with all of our debt covenants," Energy Future’s Koenig wrote in an e-mail.

KKR, TPG Capital and Goldman Sachs took an $8.3 billion equity stake in Energy Future, according to a 2008 regulatory filing.

Fees and debt-funded dividends are among the ways private- equity firms can profit from a holding without actually improving the value of a target beyond its buyout price. Debt issued to fund such dividends, known as dividend recapitalizations, has reached $54 billion this year, according to Standard & Poor’s Capital IQ LCD data, topping the record $40.5 billion in all of 2010.

"It’s one of those things they do and it helps their returns," Steven Kaplan, a finance professor at the University of Chicago’s Booth School of Business, said in a telephone interview in reference to private-equity firms. "It hurts their companies and it’s money their creditors will not get."

Income Sources

Private-equity managers have been seeking new ways to make money since deal-making sunk from the LBO boom that preceded the financial crisis. The largest firms, including Blackstone Group LP (BX), Carlyle Group LP, Apollo Global Management LLC (APO) and KKR, have started new lines of business including real estate investing, hedge fund management, credit lending and advisory services.

The firms sometimes charge initial transaction fees for advisory services to companies they purchase. The mean amount of such fees for deals from 2005 through 2010 was $11.9 million, according to a November 2011 report by Philadelphia-based Dechert and Preqin.

Private-equity firms also may charge a yearly monitoring, or management, fee for advisory services, the mean of which was $2.75 million during that six-year period, according to Dechert and Preqin, with offices in New York, London and Singapore. Energy Future’s owners said they would receive $35 million annually, increasing 2 percent each year, according to a filing with the U.S. Securities and Exchange Commission in 2008.

"Kept Alive"

"The management contract allows them to milk these fees out and that’s why the company is being kept alive," said Tom "Smitty" Smith, director of the Texas office of Public Citizen, a consumer group founded by Ralph Nader.

The fees report shows 19 percent of private-equity firms charge their portfolio companies for debt financing. Warburg Pincus LLC, for example, doesn’t make the companies it owns pay transaction and monitoring fees, according to Kaplan. Ed Trissel, a spokesman for Warburg, confirmed it doesn’t collect such payments.

When Energy Future was taken private for $43.2 billion, it was profiting from low power-generation fuel costs and rising natural gas prices. The company, under former Chairman and Chief Executive Officer C. John Wilder, posted a profit of $2.6 billion in 2006 after rebounding from a failed international expansion that left it on the verge of bankruptcy four years earlier.

"Blew Up’

Natural gas futures have fallen to $3.62 per million British thermal units from $6.88 on Oct. 11, 2007, the day KKR and TPG took Energy Future private, and a peak of $13.58 in July 2008, as a recession sapped demand and drilling expanded in the gas-rich Marcellus shale in the eastern U.S., creating a supply glut.

"A lot of investors bet on gas prices and it blew up," Andy DeVries, an analyst at debt research firm CreditSights Inc., said in a telephone interview. "They just didn’t do it in the largest buyout in LBO history — nobody did it with as much leverage as these guys."

As gas prices dropped, wholesale electricity prices plunged, hurting owners of independent generators such as Energy Future. TXU Energy, its retail business, lost 8 percent of its customers to competitors offering lower electricity rates in the first half of 2012 compared with the a year earlier.

The company had a net loss of $696 million in the second quarter, after a deficit of $1.91 billion last year and $2.81 billion in 2010, Bloomberg data show. Operating income at the energy producer last year was $383 million while interest expense on bonds was $4.2 billion.

Sustainability Questioned

Energy Future’s leverage, or ratio of consolidated total debt to earnings before interest, taxes, depreciation and amortization was 9.5 times at June 30, according to a July 31 filing with the SEC. That’s higher than every U.S. utility that has more than $1 billion in debt, Bloomberg data show. Energy Future is restricted from paying dividends to its owners using net income if its leverage is greater than 7 times, according to the July filing.

The company’s total liquidity was $3.8 billion as of Sept. 30, according to an Oct. 18 regulatory filing.

Energy Future’s "capital structure is complex and, in our opinion, untenable which calls into question the sustainability of the business model and expected duration of its liquidity reserves," Moody’s analysts James Hempstead and William Hess wrote in an August report. The ratings firm expects a "material balance sheet restructuring" as soon as 2013, they wrote.

To contact the reporters on this story:
Richard Bravo in New York at rbravo5(at)bloomberg.net;
Mark Chediak in San Francisco at mchediak@bloomberg.net

To contact the editors responsible for this story: Alan Goldstein at agoldstein5(at)bloomberg.net;
Susan Warren at susanwarren(at)bloomberg.net

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